Alert - universal credit

In some areas, new claims for tax credits are no longer possible. Whilst most existing tax credit claimants will not be affected by UC until 2019 onwards, some changes of circumstances can lead to them needing to claim UC instead. A new in-year finalisation process will be used to finalise the tax credit claim of someone who has claimed UC along with a new method of calculating income. See our section on Universal Credit for more information.

Tax Credits: Calculating tax credits

Tax credits, unlike other benefits, are based on an annual system. This section explains how to calculate tax credits.

This section of the website explains in detail how to calculate tax credits so that advisers can check HMRC calculations. Legislation changes in April 2012 meant that the calculation of tax credits is different from the earlier years. This section covers calculations under both sets of rules. Throughout the section we have tried to include a number of worked examples. These examples can be accessed as a PDF document by clicking on the relevant link.

Relevant income

In order to calculate tax credits, you need to determine the ‘relevant income’ to use. This may be the current year income or the previous year income. We explain in detail how to work out the relevant income in our ‘understanding the disregards’ section. In summary, the income to use for calculating any 2017-2018 award (whether initial, amended or final) is established using the following rules:

If 2017/18 income is less than 2016/17 income by £2,500 or less, the final award is based on 2016/17 income and there is likely to be no change in finalised award.

If 2017/18 income is less than 2016/17 income by more than £2,500, the final award will be based on 2017/18 income plus £2,500. There is likely to be an underpayment.

If 2017/18 income is greater than 2016/17 income by £2,500 or less, the final award ,like the initial award, is based on 2016/17 income and there is likely to be no change in the finalised award. Thus an increase in income of £2,500 or less is disregarded (hence the £2,500 is commonly known as 'the disregard').

If 2017/18 income is greater than 2016/17 income by more than £2,500 the final award is based on 2017/18 income less £2,500 and there is likely to be an overpayment.

The disregard for income rises decreased from £10,000 to £5,000 on 6 April 2013 and again from £5,000 to £2,500 from 6 April 2016. You can find out more about the disregards in our understanding the disregards section.

Annual and daily rates

Tax credits are paid at a daily rate throughout the award period. This means that the annual amounts announced in the Budget and shown in the table have to be converted into daily amounts. This is done by dividing the annual rate by 365 days (366 days in a leap year) and rounding up to the nearest penny.

Note: this does not apply to the WTC childcare element because this is always worked out on a weekly basis.

TCA 2002, Section 7(2) states that the income test explained at the start of this section does not apply to people in receipt of certain means-tested benefits. Those benefits are:

income support

income-based jobseeker’s allowance

income-related employment and support allowance

state pension credit (both guarantee and savings credit)

During any period that a person is in receipt of one of these benefits, they are automatically entitled to maximum tax credits. There is no tapering away of entitlement, nor counting of relevant periods. Section 7(2) makes it clear that the income test is suspended for the period during which they are receiving any of the above benefits.

The only exception to this rule is during the four-week run-on when the income test will be applied as normal even if the person is receiving one of the benefits listed above.

Important definitions

In order to understand how to calculate tax credits, it is important to understand some of the key concepts used in the legislation.

Award period

TCA 2002, Section 5 defines an award period as the ‘date on which the claim is made and ending at the end of the tax year in which the date falls’.

This is normally the same as the tax year, 6 April to the following 5 April. When a claim is made at the beginning of the year, or is backdated to the start of the tax year via the renewals process, that is when the award period also begins. It lasts until the end of the tax year unless it is terminated earlier.

Where a tax credit claimant makes a claim for Universal Credit, their tax credit award will be stopped from the day before their UC award starts and the tax credit award will be finalised. In those cases, the tax credit award period will usually end before the end of the tax year and calculation of the tax credit award will be based on the shorter award period. The way income is calculated for the stopping tax credits process is different from the standard principles which apply in the normal calculation. See our Universal Credit - stopping tax credits section for more information.

If an application for tax credits is made part way through a tax year, the award may only run for the remaining part of the year. If a claim is backdated, the award period will cover the first day of entitlement to the following 5 April and not just the period from the date the actual claim form is submitted.

Relevant period

This is a period during the award period in which the rate of tax credit a person is entitled to remains the same. A relevant period ends with a change of circumstances which changes the amount of tax credits they are entitled to.

Specifically, this means any change in the elements of WTC (other than childcare) and CTC to which the claimant is entitled. In the case of the childcare element of WTC, a relevant period comes to an end if there is a change of more than £10 in their average weekly childcare charges, or they cease paying childcare charges altogether.

In practice, most tax credits calculations shown in books, on websites and even in some HMRC materials calculate WTC and CTC together. This is because the rules in the regulations work together in such a way that once WTC is tapered away, any remaining income is used to taper away CTC and therefore the same answer is obtained.

A similar situation occurs with the use of daily rates. The legislation states that both WTC and CTC are to be calculated using daily rates. However it is quite common to see calculations of tax credits done on an annual rather than daily basis. As long as advisers are aware that this may result in a figure that is not quite accurate, it is a perfectly acceptable practice. We show examples of both daily and annual calculations in the following sections.

For advisers who would like to understand the calculation of tax credits following the strict format in the legislation, we have included a detailed explanation at the end of this section. A detailed calculation can also be seen in the HMRC manual at TCTM07APPX2 . The remainder of this section will follow the simpler method by combining the calculation of WTC and CTC.

Thresholds

These thresholds are an important part of the tax credits calculation because if a claimant’s income is above the relevant threshold their tax credits will start to be reduced (referred to as ‘tapering’). Consequently, the calculation will only be correct if the correct threshold is used.

WTC only or WTC and CTC claims

The first income threshold for WTC only, and combined WTC and CTC claims, is £6,420. One area of confusion here is around claims for both WTC and CTC. Claimants often think that the CTC only threshold applies to them because they are not getting any WTC. However a distinction must be made between a claimant entitled to WTC who doesn’t actually receive any because their income is too high versus a claimant who doesn’t have any entitlement to WTC. Where a person’s circumstances are such that they qualify for the basic element of WTC, that element along with any other elements of WTC that their circumstances dictate, should be included in the calculation and the £6,420 threshold used.

CTC only claims

Where a claimant (or their partner) has no entitlement to the basic element of WTC, but they are responsible for a child or qualifying young person, the CTC only threshold should be used. For 2017/18 it remains at £16,105.

This threshold has slowly increased since tax credits began in 2003-2004. It was not until 2011-2012 that there was a reduction in the CTC threshold. The reason for this is that the threshold is set by determining the income level at which the WTC basic element and WTC couple/lone parent elements are reduced to Nil. Above this point, CTC will start to be reduced. In 2011-2012 these elements were frozen and the taper rate was increased from 39% to 41%, thus causing a reduction in the CTC only threshold. The threshold remained the same 2012-2013 because the WTC basic and couple/lone parent elements were frozen at the 2011-2012 rates. The threshold increased from April 2013 and April 2014 due to up-rating of the couple/lone parent element. It has remained the same since 2015/16 due to a further freeze on the basic and couple/lone parent elements.

Second income threshold (2011-2012 and earlier years)

Calculating tax credits in 2011-2012 and earlier years was different to the current calculation. This is because in earlier years there were two income thresholds for WTC and CTC or CTC only claims. The first income threshold (either £6,420 or £15,860 in 2011-2012) was used to calculate entitlement to all elements except for the family element of CTC. The second income threshold was only used for the family element, which remained protected until income reached that second income threshold. From April 2012, this second income threshold was removed which means the calculation is slightly different.

The second income threshold is not a fixed figure, it depends on circumstances. However for the majority of claimants the threshold was £40,000 in 2011-2012 (£50,000 in 2010-2011 and earlier years) and it is often this figure that has been quoted. Above this threshold the family element was tapered away.

Some people had a higher second income threshold. This is because the other elements of tax credits are not tapered away fully by the time their income reaches £40,000. This is normally because they have more than two children, childcare costs or qualify for the disability elements. In such cases their individual threshold had to be calculated.

Calculating tax credits 2012-2013and later years

Each calculation of tax credits involves a series of steps which in brief are:

Determine the number of relevant periods

Calculate maximum entitlement for each relevant period by adding together the WTC and CTC elements that are applicable to the claimant’s circumstances.

Apportion the income figure and the relevant threshold for each relevant period on a daily basis.

Calculate the ‘excess income’ figure (the amount that the person’s income exceeds the threshold for that relevant period).

Calculate the ‘reduction due to income’ by multiplying the ‘excess income’ figure by the first taper percentage (currently 41%).

Take Step 5 away from the figure in Step 2 to find the tax credits for the relevant period.

Add the amount due for each relevant period to find the entitlement for the tax year.

The income figure referred to in Step 3 is the figure determined after applying the income tests set out at the start of this section . This may be previous year income or current year income (actual or estimated) depending on the circumstances.

The simplest calculation is where there is only one relevant period, with no changes to the maximum rate throughout the year. Example 1 shows the same award calculated using both daily and annual rates.

In this example, using daily rates results in a slightly higher entitlement. This is a result of rounding up daily rates to the nearest penny. As long as advisers are aware of the differences that may arise when calculating using annual figures, it is a perfectly acceptable method.

More than one relevant period

The last example involved a very simple set of circumstances with no change of circumstances during the year, so that tax credits entitlement remained the same and the whole tax year was the ‘relevant period’. Where there is a change in circumstances which alters the rate of tax credits or the elements to which a claimant is entitled, then the calculations must be done for each relevant period as Example 2 shows.

Separating WTC and CTC

When HMRC pay tax credits, they normally pay WTC to the person who is working (where both members of a couple work they can chose who receives payment) and CTC to the main carer. The childcare element is normally paid with CTC to the main carer even though it is an element of WTC.
The examples in this section have all calculated a total tax credits figure. However in order to check HMRC calculations, it is important to be able to work out how much of the total figure is WTC and how much is CTC.

To do this, an understanding of how the elements are tapered away is crucial. In Step 6 of the calculation summary at the start of this section, we said that the ‘reduction due to income’ figure (calculated under Step 5) should be deducted from the ‘maximum entitlement’ figure (calculated under Step 2) to find the amount of tax credits due for that relevant period. Whilst doing this does give the correct total figure, it doesn’t enable a breakdown of WTC and CTC to be calculated.

The legislation actually specifies that the elements that make up the ‘maximum entitlement’ figure are to be tapered away by income in a certain order. That order is:

This time the amount of each element is included for the relevant period. These figures are shown in italics and are needed in order to breakdown WTC and CTC payments.

The ‘reduction due to income’ figure in Joyce’s case is £2,492.80.

This figure is deducted from the maximum entitlement figure to tell us Joyce’s entitlement for the year but it doesn’t tell us how much WTC she will get and how much CTC which is useful to know in order to check the award notice from HMRC.

This amount is first of all deducted from the WTC basic element. As her income is fairly low, this only reduces her WTC, it doesn’t take it away fully. Joyce’s WTC is, therefore (£1,960.05 + £2,011.15 + £810.30) - £2,492.80 which is £2,288.70. Because there is some entitlement to WTC, it means Joyce receives the maximum of her CTC elements of £2,781.30 + £547.50 which is a total of £3,328.80 CTC.

If Joyce had an income of £25,000, her reduction due to income would be £7,617.80 (income less threshold x 41%). Her tax credits entitlement would be reduced as follows:

£

£

£ reduction remaining

Reduction due to income

(7,617.80)

WTC basic element

1,960.05

Nil

(5,657.75)

WTC lone parent

2,011.15

Nil

(3,646.60)

WTC 30 hr

810.30

Nil

(2,836.30)

CTC child element

2,781.30

Nil

(55.00)

CTC family element

547.50

492.50

(Nil)

Joyce’s total tax credit entitlement is £492.50 for the year and that is a payment of the family element of CTC. Entitlement to all other elements has been reduced to Nil because of Joyce’s income.

One other point which this demonstrates is the importance of including all elements in a calculation. Even though a claimant might not actually receive a payment of WTC because their income is too high, including additional elements in the calculation (such as the childcare or disability elements) means that the person may receive more CTC because it won’t start to be reduced until much higher up the income scale.

The childcare element

As explained in our ‘understanding childcare’ section, the childcare element is calculated on a weekly basis rather than daily.

Technically, the legislation requires two small calculations to be done in order to determine the childcare figure to use in the calculation.

Calculation 1

The actual ‘average weekly childcare costs’ for the relevant period should be calculated.

This involves multiplying the ‘average weekly childcare costs’ (see ‘understanding childcare’ on how to calculate this figure) by:

(52 / N1) x N2

N1= Number of days in the tax year
N2= Number of days in the relevant period.

Calculation 2

The second step involves calculating the ‘prescribed maximum childcare costs’ for the relevant period. The maximum childcare costs that can be claimed are 70% of the prescribed maximums which are £175 for one child and £300 for two or more children.

This involves taking whichever maximum amount applies (£175 or £300) and dividing it by 7, rounding the result up to the nearest penny before multiplying by the number of days in the relevant period.

Once you have calculated both figures (the actual costs and the prescribed maximum costs), the lower figure is taken and multiplied by 70% (the answer then being rounded up to the nearest penny).

Where average weekly childcare costs exceed the maximum rate, then the steps above need to be followed as shown by Example 3.

In practice, if average weekly childcare costs are less than or equal to £175 or £300 there is no need to do both calculations (because the actual costs will always be lower than the prescribed maximum). The actual costs figure can simply be used in the calculation of maximum rate as Example 4 shows.

Calculating income cut off points

Sometimes it is useful for advisers to be able to calculate the cut-off point for a specific group of tax credits claimants, and as the family element of tax credits is no longer protected until income reaches a certain level, every claimant will have a different income level at which their tax credits will reduce to Nil.

The calculation of this income level for WTC only or WTC and CTC claimants (those who are on the 1st income threshold) is shown in Example 5.

Calculating tax credits 2011-2012 and earlier years

For WTC only claimants, the calculation of tax credits in 2011-2012 and earlier years was as outlined in the previous section and for that group nothing has changed calculation wise (although thresholds and taper percentages have changed over the years).

The main change is for claimants who are entitled to CTC. In 2011-2012 and earlier years there was a second income threshold. For most claimants this threshold was £40,000 in 2011-2012 and £50,000 in 2010-2011 and earlier years. The second income threshold was only relevant to the family element of tax credits and meant that families were guaranteed at least £545 until income exceeded the second income threshold.

For this reason, the calculation separated out the family element from all other elements.

Earlier in this section we calculated that Joyce, would be entitled to only £492.50 if her income was £25,000. If those circumstances had applied in 2010-2011, the calculation would have been as set out in Example 6.

As can be seen in Example 6, Joyce would have received the full amount of the family element because her income was below the second income threshold (in her case £50,000)

Calculating the second income threshold

For most people the second income threshold was £40,000 in 2011-2012 (£50,000 in 2010-2011 and earlier years). The one notable exception to this was for families whose elements of tax credits other than the family element had not been tapered away by the time income reached £40,000. Such families would have a higher second income threshold that needed to be individually calculated.

This was a complicated part of the system, not helped by HMRC who often quoted the £40,000 as an absolute cut-off point when in fact, as the examples below show, families with incomes much higher up the scale could still qualify because their second income threshold was higher than £40,000. Example 7 shows how this second income threshold was calculated.